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U.K. Economy Suffers a Reversal

By

Alistair MacDonald

Updated Jan. 26, 2011 12:01 a.m. ET

An employee welds metal on a cruise ship at the A&P Falmouth shipyard operated by A&P Group Ltd. in Falmouth, U.K.
Simon Dawson/Bloomberg

LONDON—The U.K.'s snow-battered economy shrank for the first time in more than a year during the fourth quarter of 2010, a surprise negative hit that will trigger debate about the country's aggressive fiscal tightening and the direction of interest rates amid high inflation.

Gross domestic product fell 0.5% in October through December, after expanding by 0.7% in the third quarter, according to preliminary estimates from the Office for National Statistics. The drop is the first quarterly contraction in GDP since the third quarter of 2009 and contrasted with the 0.4% growth that economists had expected.

An official from the statistics office said extreme weather at the tail end of 2010—which resulted in the coldest December in over 100 years—was likely to have been a large cause of the contraction. Many economists also point to recent strong business surveys to illustrate the recovery.

But, the bad news wasn't just confined to December, with its hard-hit services and construction sectors. Even without the December snow, economic growth was flat in October and November from the third quarter, Credit Suisse says.

Tuesday's data are likely to support the case for the Bank of England holding off raising interest rates in the near term, despite a jump in the U.K.'s inflation rate to 3.7%, nearly double the 2% central bank's target level.

In a speech on Tuesday, central bank Governor Mervyn King said the numbers were a reminder that "the recovery will be choppy" but that "the U.K. economy is well placed to return to sustained, balanced growth over the next few years."

Referring to the U.K.'s austerity drive amid a weak economy, Mr. King said: "the right course has been set and it is important we maintain it."

Looking ahead, the U.K. faces a high inflation rate, an increasingly cautious consumer, and cuts and tax increases valued at around 8% of GDP over the next four years.

"It seems that the economy is incredibly vulnerable. And with the fiscal tightening yet to fully bite, economic growth will remain subdued this year," said Hetal Mehta, U.K. economist at Daiwa Capital Market Europe, who described the GDP figure as "horrendous."

Opposition politicians argue that the economy showed early signs of the effects of the coalition government's aggressive spending cuts and the poor numbers are a reminder that the economy is still fragile.

Public finances provided one piece of good statistical news for the government, with the net amount the country needed to borrow in December 2010 coming in less than expected at £16.8 billion, down from £21 billion in December 2009. Financial markets have severely punished European countries, such as Ireland and Portugal, which investors believe have weak public finances.

The cuts have positioned the U.K. as a global test case in the argument for choosing austerity over stimulus to repair the economy. Tuesday's numbers are likely to leave the U.K. lagging behind Europe's other big economies, France and Germany.

Sterling fell sharply to $1.5765 from $1.5908, and the euro was climbing rapidly against sterling after the data, trading around 86.29 pence from 85.67 pence.

The other big driver of Britain's recent growth was government spending, which in the coming fiscal year alone is to be cut by £23 billion.

U.K. Treasury chief George Osborne said the government wouldn't change its fiscal plans following the unexpected contraction. "That would plunge Britain back into a financial crisis," Mr. Osborne said in a statement. "We will not be blown off course by bad weather."

The fall in the fourth quarter means that the U.K. economy grew by 1.4% in 2010, after contractions of 4.9% in 2009 and 0.1% in 2008. Some economists had predicted much worse growth at the beginning of last year and Tuesday's poor number comes after what had been a robust recovery for a country once seen as having a much higher risk.

Up to the third quarter, the U.K. had enjoyed its fastest four-quarter recovery in its postwar history, according to Lombard Street Research.

Lombard Street economist Jamie Dannhauser said that this last quarter should not be seen as an end to that, with the strong business spending and business confidence of recent surveys showing underlying strength.

Other are less convinced. Martin Chapman, who runs a wine distribution business outside of Oxford, England, said he was not surprised by Tuesday's numbers.

Christmas wine sales were down by up to 20% from 2009, in what Mr. Chapman believes shows that the rest of the country is also uncertain about the recovery. Before, customers average spend was a £10 to £15 for a bottle of wine and now they spend £8 to £10.